Incoming President Xi Jinping: Changes Ahead for U.S.-China Relations

During his visit to the U.S. in mid-February, Chinese Vice President Xi Jinping hit many perfect notes. Expected to take over as both China’s President and general secretary of the Chinese Communist Party within the next year, the 57-year-old heir apparent visited President Barack Obama at the White House on Valentine’s Day. He then attended a reunion with the Muscatine, Iowa, families with whom he had stayed during a 1985 trip, and he wound up his tour by watching a Lakers basketball game in Los Angeles with the city’s mayor. Despite parrying with U.S. officials over remarks about human rights and other concerns, Xi, married to Chinese folk singing star Peng Liyuan, told news outlets: “I can now say my visit to the United States has been a full success.”

When Xi takes over as the leader of the second biggest economy in the world, will U.S.-China economic relations take a cue from this recent visit and become more harmonious? Chances are, despite Xi’s smooth U.S. sojourn, tensions between the two countries will continue, analysts say. Given the evolution of China’s economy, the biggest flashpoints are likely to shift. While currency manipulation may remain a sticking point, complaints about unfair state support of China’s economy at the expense of U.S. competitiveness are expected to reach a crescendo, according to China experts at Wharton and elsewhere. The apparent success of China’s state-directed economic growth, dubbed the Beijing Consensus, is now pitted against the market-based approach of the Washington Consensus.

Reactions to this development vary. “Attacking [Chinese] state-owned enterprise subsidies should be our top priority,” says Derek Scissors, a research fellow at the Heritage Foundation, a Washington, D.C., think tank. In contrast, Wharton management professor Marshall W. Meyer, who is writing a book about U.S.-China economic relations, notes: “You can’t tell [Chinese officials] what to do, but you can play their game, or invent a better game. Playing the game means a bigger role for [the U.S.] government.”

‘More of a Hu Than a Zhu’

Few can predict with any certainty which way Xi Jinping himself will go on the issue. “We have no idea: Is Xi Jinping a Zhu Rongji or a Hu Jintao?” asks Meyer, referring to China’s former Premier and its current President, respectively. “The betting is that he is more of a Hu than a Zhu, but nobody can be sure.” Zhu Rongji, China’s Premier from 1998 to 2003, was known as a dynamic economic reformer who scaled back the power of the state in favor of the private sector, while current President Hu reinvigorated state-owned enterprises as a dominant force in the Chinese economy, especially via the central government’s stimulus funding in the wake of the 2008 global economic crisis.

The transition of top political leadership in China, which has taken place every 10 years since Jiang Zemin took over from Deng Xiaoping in 1993, offers the “possibility of big change,” says Scissors. Like Meyer, Scissors is skeptical that Xi will embrace that opportunity. Reform of the state-dominated economy “would be a lot for him to take on,” he says. After all, Xi is from the class of children and relatives of the People’s Republic of China’s founding revolutionary cadres, now benefiting from the state-owned enterprises dominating China’s economy today.

By all external measures, Xi is a prototype of that class. His father, Xi Zhongxun, was a Communist revolutionary hero who later became Vice Premier. Today, Xi Jinping enjoys the perks of the Chinese upper class — with a daughter studying at Harvard University and a glamorous celebrity wife. Yet, he has not always led a charmed life. In 1962, when his father fell out of favor, Xi Jinping suffered a rude awakening, sent down from Zhongnanhai, the elite Communist leadership compound where he lived, to dwell in a cave in impoverished Liangjiahe, Shaanxi Province, for seven years.

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In the end, the impact of these or other experiences on Xi may not make a big difference for policy, say some experts. Xi is only one of nine members of the Politburo’s Standing Committee, where seven members will change over this fall, along with nearly half of the 25 members of the entire Politburo, notes Adam Hersh, an economist specializing in China at the Center for American Progress, a Washington, D.C., think tank. “One person does not pull all the strings that make the Chinese economy dance,” he says. “The big question is the overall balance of internal party factions and ideologies.”

A ‘Sideways’ Future

Meanwhile, China’s economy will be facing significant challenges, including a population that is growing old before it grows rich, widening inequality and labor unrest. “China is not going to be as big a bogeyman, because it will be preoccupied by internal problems,” says Meyer. “As the Chinese become more dependent on imported energy and food, China’s balance of payments [surplus] isn’t going to be nearly as huge as before. The combination of inflation and the aging of the Chinese population is likely to cause the Chinese economy to go sideways. The decelerated growth of the economy will pose real challenges for the leadership, whose concern is keeping the growth machine growing, people employed and everybody fed.”

At the same time, the U.S. is going through its own presidential election cycle and economic trouble, which ensures that rhetoric against China will be especially loud, Meyer adds. Regardless of who is elected, “we’ll go through a new round of China bashing…. It’s standard operating procedure.” If the U.S. economy persists at low growth rates and high unemployment, amid a continued trade deficit with China, pressure on China is likely to mount.

In that context, Washington will continue to complain that an undervalued renminbi (RMB) is to blame for the trade deficit, according to Hersh. The Chinese currency’s real exchange rate with the U.S. dollar has appreciated nearly 40% since 2005, states Pieter Bottelier, an adjunct professor in China Studies at Johns Hopkins University’s School of Advanced International Studies in Washington, D.C. Bottelier notes that China’s overall current account surplus has declined to 3.7% of GDP from a peak of more than 10% in 2007 and is now below the 4% mark that U.S. Treasury Secretary Timothy Geithner uses as an indicator of external imbalances. But China continues to run a trade surplus with the U.S.

According to Wharton finance professor Franklin Allen, “The big decision Xi will have to make is whether to internationalize the RMB to serve as a reserve currency.” To manage the RMB within certain exchange-rate bands, China keeps massive foreign exchange reserves amounting to about 50% of GDP and costing 1% to 2% of GDP a year, says Allen. If the RMB were freely convertible, China would not have to keep as many reserves. But the Chinese government would have to move carefully, since it is hard to predict how much money would flow out of the country. Moreover, if the RMB becomes a reserve currency, China would stop financing the U.S. budget deficit by buying Treasuries for its reserves. “If they get rid of our reserves, that’s a huge problem for us,” says Allen. “It’s right to be cautious rather than to institute change with a big bang.”

‘Innovation Mercantilism’

Broader concerns about U.S. competitiveness are likely to prevail and lead to demands from Washington beyond exchange rates, striking closer to the heart of China’s market structure and internal government subsidies. Rob Atkinson, founder and president of the Information Technology and Innovation Foundation, a Washington, D.C., technology policy think tank, is now raising the specter of what he calls China’s “innovation mercantilism.” China’s drive for “indigenous” innovation, launched six years ago, says Atkinson, is resulting in massive government subsidies to state-owned enterprises to generate technological innovations without regard to intellectual property rights and other rules of fair play.

“The Chinese are employing multiple tools to achieve their goal to incorporate, redo and get as much foreign technologies into the hands of Chinese companies as possible,” he notes. “In the past, when they were engaged in a foreign-direct-investment attraction strategy, making Happy Meal toys, or in low value-added commodity-based manufacturing assembly, they weren’t as much a threat to the U.S. economy. Now, they are more of a threat to U.S. multinationals. The real flashpoints over the next few years will be around intellectual property rights, including trade secrets.” According to Atkinson, many sectors have been affected by this trend, including high-speed rail, semiconductors and wind energy.

Scissors of the Heritage Foundation agrees that the U.S. should take steps to curtail the power of state-owned, state-funded enterprises and their disproportionate market power. The U.S. can do so by using carrots, such as access to the U.S. market for investment, and sticks, such as U.S. executive branch or congressional objections to Chinese state-owned companies’ plans to invest in U.S. firms. Another potential negotiating tool is the Obama administration’s Transpacific Partnership (TPP), a multilateral free trade agreement aimed at expanding free and open trade and investment among Asian and Pacific nations. Currently, countries including Australia, Japan and Vietnam are working to gain membership. “If you create a vibrant TPP with rules for state firms, China may be excluded,” Scissors notes. “It would be an incentive for China to change its behavior.”

The pressure to reform the state-dominated economy is mounting from many quarters. A February 27 report, titled “China 2030: Building a Modern, Harmonious, and Creative High-Income Society,” issued jointly by the World Bank and the Development Research Center of China’s State Council, recommends that China complete its transition to a market economy and grow into a high-income country by 2030 by strengthening the private sector, opening its markets to more competition and innovation, and ensuring greater equality of opportunity. Among other recommendations, the report urges the government to redefine the role of state-owned enterprises, break up certain monopolies and take measures to support the growth of the private sector. “China’s leaders have recognized that the country’s growth model, which has been so successful for the past 30 years, will need to be changed to accommodate new challenges,” saidWorld Bank Group president Robert B. Zoellick in a press statement.

Hoping for such reform may be too optimistic, according to Wharton’s Meyer. “This is what we would wish for,” he says. “The question is whether it is going to happen. It may not happen, and we may have to deal with a different model.” To engage with Beijing’s model, the U.S. may have to transform itself, he notes. “Their government acts like a government, doing what it must to grow GDP and to employ people. Ultimately, someone has got to say there’s room [in the U.S.] for a growth model along with our shareholder value model. We have to be flexible and adapt.”

If, as expected, Xi Jinping ascends to the top leadership role in China, the challenges he faces with the U.S. and domestically will continue unabated, presenting both the Beijing Consensus and the Washington Consensus with new tests. But, says Bottelier of Johns Hopkins’ SAIS: “The U.S. and China are the two largest economies, and that suggests these two nations, like it or not, have to support each other on global issues. If they don’t, the world could face much more serious problems.”